September 1, 2003

Opt Out

On July 8, Microsoft CEO Steve Ballmer shocked the business world by
announcing that, starting in September, the trend-setting software
giant would stop compensating its employees with stock options--the
right to buy a given quantity of stock at a fixed price--and
instead hand out restricted shares of the company itself. What's
more, he announced that the millions of options Microsoft granted
during the last 20 years, which turned middle managers into
millionaires and helped launch the dot-com boom, would be
retroactively calculated into the company's future financial
statements.It was a dramatic move. By not expensing options, thousands of
companies-- including Microsoft--lowered their personnel costs in
the 1990s and thereby artificially boosted profits. What's more,
because companies generally did report options as costs on their
tax returns, they received significant tax write-offs. For example,
thanks to its heavy use of options, in 2000 Enron went from owing
$112 million in taxes to receiving a $278 million refund.

Ballmer's announcement is not quite the unilateral disarmament it
might appear. This fall, the Federal Accounting Standards Board
(fasb), which sets the country's financial reporting rules, intends
to mandate stock-option expensing for all businesses. Microsoft's
decision, says William Patterson, director of the afl-cio's office
of investment, marked "the end of the golden age of stock
options."

But, even as the fasb--and companies like Microsoft--consider
reform, there is a growing backlash, particularly in the high-tech
industry, where un- expensed stock options form the backbone of
many a company's compensation strategy. Lobbying groups, such as
AeA (formerly the American Electronics Association) and the
Information Technology Industry Council (itic), are canvassing
Washington in an attempt to block the fasb rules--even though that
could derail future corporate reforms, sink investor confidence,
and, as a result, cripple the fragile economic recovery.

And who has Silicon Valley recruited to do its dirty work?
Congressional Democrats--the same folks who made such hay about the
need for corporate reform after last year's Enron and WorldCom
scandals. Problem is, as enthusiastic as Democrats may have been
for reform in the abstract, they can't afford to anger the
high-tech industry, one of a shrinking number of business sectors
that gives generously to Democratic candidates. According to the
Center for Responsive Politics, in 2002 computer and software
manufacturers gave the Democratic Party and its candidates $7.8
million; overall, 15 of the industry's top recipients were
Democrats. So, in recent months, prominent Democrats have rallied
behind a moratorium on new fasb options rules proposed by
Democratic Representative Anna Eshoo and Republican Representative
David Dreier. The bill's supporters include presidential hopeful
Dick Gephardt and campaign finance reform crusader Martin Meehan;
even Minority Leader Nancy Pelosi, while not a co-sponsor, has
signaled her support. The anti-expensing fervor reaches into the
Senate as well, where Barbara Boxer has introduced similar
legislation and presidential candidate Joe Lieberman has signaled
his support. Indeed, it was Lieberman, with his 100 percent
approval rating from the itic, who led successful efforts to block
expensing rules in 1993 and 2002. And, while both bills have broad
bipartisan support, it is the Democrats who claim the leadership
mantle--Eshoo in the House and Lieberman in the Senate. "I've been
on this for ten years and six months," boasts Eshoo. "I'm not an
Anna-come- lately." All of which raises an uncomfortable question
for the Democrats: How serious are they about corporate reform
after all?

Since last summer, requiring the expensing of options has been a top
priority of corporate reformers. And it's not just because of the
tax loophole: As former Federal Reserve Chair Paul Volcker recently
told a House subcommittee, un-expensed options were a "contributing
factor" in the 2002 corporate scandals. Thanks to their free-money
allure, options made up more than 40 percent of executive
compensation during the late '90s. This gave executives an enormous
incentive to pursue risky, even illegal, strategies to boost stock
prices so they could exercise their options and immediately sell
their stock. "[Options] are ... clearly temptations for abuse,"
Volcker explained. "[T]he incentive is given to the manager to
attempt to affect the price of the stock, sometimes in ways that
are inconsistent with the long-term health of the company."
Expensing options, reformers argue, would enable investors to
better uncover such financial finagling.

Last year, at the height of the corporate scandals, Senators Carl
Levin and John McCain tried to attach expensing legislation to the
Sarbanes-Oxley corporate-reform bill. But that effort was blocked,
largely by Lieberman, who led the anti-expensing p.r. charge, and
then-Majority Leader Tom Daschle, who refused to schedule the
measure for a vote. After the Levin-McCain amendment was buried,
the itic sent Daschle a letter thanking him for his "support for
the high-tech industry's position against the expensing of stocks."

For a while, it seemed the lobbyists had won. But earlier this year,
a new front opened up: The fasb, an independent organization funded
by corporate contributions, announced it would consider the matter
itself and release new rules within a year. And, again, the
high-tech industry responded aggressively. Before the fasb had even
begun its work, Eshoo and Dreier sent the board a letter expressing
"strong opposition to any proposal which would mandate the
expensing of broad-based stock option plans." The letter made its
case largely along two lines: that options were impossible to
expense and that doing so would force companies to stop giving them
to rank-and-file employees. "[M]andatory expensing would
effectively destroy broad-based stock option plans, " the letter
claimed.

But such arguments are widely dismissed by accounting experts and
investors. They point out that many things are hard to value
precisely--machinery depreciation, for example--and yet
nevertheless appear on financial statements. And, while it's true
that an expensing requirement might drive some firms to drop
stock-options plans, for the most part options are too much a part
of corporate culture to simply disappear. If expensing becomes a
rule, "broad- based plans will continue," says Corey Rosen,
executive director of the National Center for Employee Ownership, a
group that advocates stock-option plans. "Only the companies that
aren't so committed won't keep doing it." Moreover, it's hard to
argue with the retinue of big names who have come out in favor of
expensing: Securities and Exchange Commission (SEC) Chair William
Donaldson, former SEC Chair Arthur Levitt, Warren Buffett, and Alan
Greenspan, to name a few.

Nevertheless, the tech world and its supporters have pulled out all
the stops. In March, Eshoo and Dreier introduced the Broad-Based
Stock Option Plan Transparency Act, which would prevent the fasb's
rules change from being accepted as general practice. While the
bill has its merits--it also requires, for example, in-depth,
"plain-English" explanations of a company's option plans- -it
nevertheless represents a dire threat to the fasb, an organization
whose efficacy, like that of the Federal Reserve Board, depends on
its being insulated from the political process. The implications
for future corporate reforms are striking, says Dennis Beresford,
an accounting professor at the University of Georgia and a former
fasb chair. "The danger in something like this is that, anytime
anybody in Congress or one of their contributors doesn't like
something [the fasb is doing], then they just enlist their friends
in Congress to take issue with it."

Indeed, the Eshoo-Dreier bill could hurt the economy in two ways.
First, by politicizing the accounting process--a key component of
corporate reform--the bill could hurt investor confidence, which
has stayed afloat largely on the assumption that efforts to reform
boardroom and accounting procedures will go forward. "We have all
witnessed the ... loss of investor confidence in financial
reporting that have resulted from companies intentionally violating
or manipulating accounting reports," fasb Chair Robert Herz told the
House Subcommittee on Capital Markets in June. "What impact, then,
on the system and on investors' trust on financial reports might
there be if it were perceived that accounting-standard setting was
being deliberately biased?" Second, bad accounting allows
underperforming companies to color their numbers and thus attract
investment--again, think Enron--ensuring an inefficient distribution
of capital and, in turn, poor market performance. "The more we can
get stock prices to reflect the value of companies," says ucla
accounting professor Brett Trueman, "the better the economy will
be."

But expert opinion hasn't deterred Eshoo and Co., who say they will
push to get their bill onto the House floor after the August
recess. Antiexpensing Democrats in the Senate have also been
pursuing the issue; in May, shortly after introducing her companion
legislation, Boxer convened a roundtable "discussion" in which 17
lobbyists and industry allies ganged up on Herz, one of only three
pro-expensing panelists.

While Eshoo-Dreier is still in committee, its chances of passing
have improved substantially in the last couple of months--thanks in
part, ironically, to Microsoft. By adopting expensing rules
voluntarily, the company has provided ammunition to anti-reform
forces, who argue that new legislation and accounting rules are
unnecessary in an environment in which companies police themselves.
"I would have said the chances were very slim, but now I wonder,"
says Trueman. "The momentum might be on the side of those against
expensing for the time being."

Anti-expensing Democrats are doing their best to deflect accusations
of corporate cronyism, arguing that un-expensed stock options are a
key to future growth. "Fasb told me they don't have any economic
responsibility, that it's not something they have to take into
consideration," Eshoo says. "And I understand that. But I do
believe that Congress does." Unfortunately, it appears Eshoo has
confused the country's economic interests with those of her
business allies.